The foreign exchange (FX/forex) market is a colossus dwarfing the world’s equity and bond markets. Yet it remains remarkably opaque requiring intensive attention to detail, process discipline and client-first values to ensure that institutional investors’ FX exposures are properly managed. Even small cost slippages can be detrimental when large sums are at stake.
Estimates put the value of the global forex market at around $US5.3 trillion-a-day1 and yet it is among the least regulated parts of the world’s capital markets.
The state of California’s 2009 lawsuit against State Street Bank in 2009 gave uncomfortable insights into some of the forex industry’s moral hazards. Regrettably, that episode was not the end of rate fixing scandals.
A brief recounting of subsequent indignities makes for head-shaking reading.
Barclays and four other major banks paid multi-billion pound fines earlier this year after admitting to collusion in manipulating currency exchange rates. Traders colluded on rates between themselves and counterparty banks to remove both risk and competition, to the detriment of their clients.
The much-publicised Libor scandal revealed a similar potential for ethical compromises, this time in relation to the reporting of interbank interest rates.
Recently BNY Mellon agreed to pay US$714 million to settle allegations that the bank overcharged pension funds and other clients for foreign exchange services. However, rather than leading to contrition and changed behaviour by service providers, some felt exonerated owing to disclosures made as part of their settlements and became quite open in communicating their practices.
A case in point being the following sentences from JPMorgan’s disclosure notice2:
“We added markup to price quotes using hand signals and/or other internal arrangements or communications."
"We have, without informing clients, worked limit orders at levels (i.e., prices) better than the limit order price so that we would earn a spread or markup in connection with our execution of such orders."
"We made decisions not to fill clients’ limit orders at all, or to fill them only in part, in order to profit from a spread or markup in connection with our execution of such orders."
The best that can be said is that clients have been warned. It really is a case of “buyer beware.”
Offshore investing is growing
With institutional investors increasingly targeting offshore investments, it’s more important than ever to ensure thorough oversight of currency exposures. Minimising risk is paramount but flexibility and best-practice implementation can enhance portfolio outcomes and minimise trading expenses.
The average Australian superannuation fund’s exposure to foreign currency rose to 18.2 per cent in 2013 from 17 per cent in 20113.
Growth in underlying assets combined with higher percentage exposures to foreign currency means that superannuation funds in 2013 had A$278 billion exposed to movements in the currency – A$59 billion more than in 20114.
The figure will be considerably higher now.
FX moral hazard
The FX market lacks the exchanges and regulatory oversight and transparency of listed markets. Still, most participants do the right thing and have appropriate internal governance and oversight systems to ensure that they act properly.
However, on occasions, some industry participants have put their financial interests before their fiduciary obligations to clients by front-running orders and over-charging on FX transactions.
Moreover, when trader remuneration is tied to the broadening of spreads on unassuming clients, investor returns can be compromised.
The illiquid, volatile and opaque nature of over-the-counter FX markets have long left the onus on the investor to ensure their provider is working to find them the best liquidity and pricing opportunities.
The costs of poor oversight can be huge. Estimates suggest FX execution costs fall by 40 to 80 per cent after transaction cost analysis is employed.
It’s estimated that even a 0.01 per cent slippage in transaction costs can sum to over A$1 million in maintaining a A$1 billion currency hedge over a year.
A great deal can be done on the cost and efficiency side when managing FX transactions including:
When choosing a currency overlay manager the focus should be on investment providers renowned for transparency and fairness.
Other do’s include:
Currency trading best practice
We go to great lengths to avoid the potential for conflicts of interest relating to FX trading on behalf of clients. Processes, practices and systems in place to do so and ensuring the best outcome for clients include:
Institutional clients place trust in their FX managers to do the right thing. Sometimes, there has been an abuse of trust.
The unregulated nature of currency markets places great responsibility on institutional clients to bestow this vital function to service providers with a fiduciary mind-set who consistently aim for best practice implementation.
1BIS Triennial Central Bank Survey, 2013: http://www.bis.org/publ/rpfx13fx.pdf
3NAB Superannuation FX Survey, 2013
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